Have We Created a Two-Tiered Tax System -- One for the Powerful and One for the Rest of Us?

Unlike the rest of us, many high-income, influential people and organizations have close to a free hand when it comes to their taxes. Already underfunded and understaffed, the IRS seems incapable of stopping many aggressive or even abusive interpretations of the tax laws, often by hedge funds or politically-motivated tax-exempt organizations.

Over the past few weeks, two powerful examples of this bifurcated system have bubbled to the surface.

Last night, the Senate Permanent Subcommittee on Investigations issued a report on how some hedge funds and banks use derivatives to turn short-term capital gains into long-term gains and, thus, save billions of dollars in taxes. According to the committee staff, the partners of just one fund, Renaissance Technology Corp., used these transactions to avoid $6.8 billion in taxes from 2000 to 2013. One hedge fund. $6.8 billion.

The IRS has known about tax avoidance through these derivatives (called “barrier options” or “basket options”) for six years, according to testimony by Renaissance officials. Yet my Tax Policy Center colleague Steve Rosenthal—a tax lawyer who specialized in complex financial transactions when he was in private practice– believes that claiming long-term gains through derivative transactions such as those used by Renaissance is already against the law.

The IRS doesn’t need any new legal authority to stop this activity, yet it can’t seem to do it.

The problem is the IRS is hopelessly outgunned, especially when it comes to complex areas of the law where aggressive entities can marshal armies of lawyers. In 2011, partnerships held $2.3 trillion in assets and reported $69 billion in income. But Amy S. Elliot of Tax Notes reports that the field audit rate for large partnerships was 0.8 percent.

In part, that’s because the agency was unlikely to collect any money from these entities. As pass-throughs, partnerships pay no taxes. Thus, the IRS was reluctant to audit them. The problem: businesses increasingly are organizing themselves in this manner, and the IRS has been unable to keep up.

The partners pay tax, of course, but they’d be subject to individual audits. Though the agency can always track that income back to the partnership itself, it rarely bothers. In effect, the agency usually takes the K-1 income a partner receives from his hedge fund at face value.

Then, there is the matter of those 501(c)(4) tax exempt social welfare organizations. These were once community groups whose jurisdiction resided in a sleepy corner of the IRS. But since the Supreme Court’s Citizen United decision, they have become the go-to vehicle for the wealthy and powerful to contribute anonymously to political candidates. In 2013, according to the Center for Public Integrity, these organizations distributed $256 million in dark money to favored politicians.

For more than a year, we’ve read about the IRS’s ham-handed handling of their applications for tax-exempt status. But while critics have focused on the IRS’s alleged targeting of certain organizations, they have ignored another, quite different story. According to a recent report by the non-partisan Center for Public Integrity, the audit rate for non-profits is 0.66 percent, even lower than for partnerships.

Even prior to the recent wave of budget pressures and well before Congress and the Obama Administration dumped even more work on the agency through the Affordable Care Act, partnerships and tax-exempts were IRS backwaters.

And like the partnerships, the benefit of auditing the 501(c)(4)s didn’t justify the cost. Until recently, at least.

These are extreme cases, but the IRS is desperately short-staffed everywhere. In 2013, the agency had fewer enforcement staff than a decade ago. And the problem would get far worse under the agency budget just passed by the House—which would slash funding by $1.4 billion, or 13 percent.

There are enormous consequences for tax compliance when ordinary people come to believe there are two tax systems—one for the rich and one for them. But it appears that is exactly what is happening. Some may think that’s just fine. I don’t.

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“The partners pay tax, of course, but they’d be subject to individual audits. Though the agency can always track that income back to the partnership itself, it rarely bothers. In effect, the agency usually takes the K-1 income a partner receives from his hedge fund at face value.”

Aren’t most or all of these hedge funds TEFRA partnerships and subject to audit at the partnership level?

Frankly, the lack of enforcement at the IRS doesn’t lead me to believe that we need more agents. Instead, that’s conclusive evidence for the need to vastly and dramatically simplify the Internal Revenue code. I would even welcome gutting the IRS completely to instead implement the Transaction tax (http://thetransactiontax.org).

You left out the revolving door. I’ve been told that the ambition of most of the lawyers in the Chief Counsel’ office is to work for the Big 4.

If we were serious about the deficit the government would increase IRS salaries and raid the Big 4 tax departments for the people who know the likely place where corners were cut and bodies are buried.